Sunday, August 17, 2014

Most entrepreneurs struggle with financial projections, not wanting to commit to numbers they can’t deliver, and having no clue what investors might consider reasonable. However, making no projections, or non-credible projections will get your startup marked as unfundable. I recommend a simple set of guidelines, which work for at least 80% of the business domains I see.

Equally important, you need to make these projections first as goals for your own use, to convince the team as well as investors that you have a business which is achievable. Projecting the financials should be the last step of your business plan preparation, since it assumes you already know the opportunity size, customer buying habits, pricing, costs, and competition.

Here are some basic “rules of thumb” that every Angel or venture capital equity investor uses, to help you anticipate their reactions. The rules are obviously not absolute, but you must be prepared to explain to potential investors why your startup is the exception to these guidelines:

Five-year financial projections are the norm. According to a recent Dow Jones VentureSource report, the average time to liquidity of an equity investment in a startup is now about five years. Thus most investors ask for 5-year projections, to get a sense of the opportunity and trajectory that you’re envisioning while their money is tied up.

Aggressive revenue projections and growth rate. The first filter applied by most investors is to identify high-growth investable startups from ones that may be a good family business with organic growth, but could never generate a 10x return. Revenue in the fifth year should be at least $20 million, with a growth rate average of 100% per year.

But don’t go crazy with this number. If your fifth year projection exceeds $100 million, that puts you in the rare category of the next Google, and probably won’t be credible with investors, unless you have a track record in this range. In other words, revenue projections are not the place to be too conservative or wildly optimistic.

Gross margins greater than 50%. Most entrepreneurs, with no experience, believe that they can make good money with lower margins than competitors. The reality is that even if you eat Raman noodles and do survive with low margins, your growth rate will be stunted, yielding a low return for investors.

Financial projections for investors should always show an annual cost of goods sold and gross margins line, as well as revenue. Low gross margins in the first couple of years are expected, but they better climb to the 60% range by year five.

Show red ink to match your funding request. Financial projections shown to investors should always be pre-funding projections, to illustrate what revenues and expenses you think are possible, and how much your current funding falls short. Don’t ask for funding if your projections imply you don’t need it. Investors don’t like their money used frivolously.

If you show a negative cash flow of $800 thousand before the business turns cashflow positive, it is fair to buffer that amount by 20% and ask for a $1 million investment, since we all know that there will be un-anticipated additional costs.

Build a path to 10x return. The only path to any return for equity investments is a liquidity event, like a merger or acquisition (M&A), or IPO. That’s why investors want to hear about your exit strategy. If you don’t have one, or intend to buy out investors with their own money, you probably won’t get much interest.

What investors want to hear is that your company will demonstrate that high rate of growth to get you to $50 million in revenue in 5 years, making you a premium acquisition alternative to one of your partners, selling for 5 times revenue, for a total of $250 million. That makes their $1 million investment for 10% equity worth $25 million, or 25x.

Be aware that investors will be testing your financial projections in real time against your opportunity numbers, volume projections, pricing model, and performance to date. If you have no data in one of these areas, be prepared for the “come back when you have more traction” message. Investors don’t want to antagonize a potential winner, but you are not fundable yet.

Of course, the quality of your management team, or demonstrated performance in prior similar ventures, can override any or all of these rules of thumb. On the other hand, you must remember that only about one percent of Angel investor funding requests get satisfied, according to the Angel Capital Association. Venture capital requests that get satisfied are even lower.

Overall, financial projections that make sense in your business domain, and cross-foot with available data from independent market analysts are no guarantee that you can deliver. They do show you already stand out from the crowd of talk-only entrepreneurs, understand financial realities, and are willing to commit. What more could an investor ask, since he is really investing in you, not the numbers?